Financial Statements

Knowing how to work with the numbers in a company's financial statements is an essential skill
for stock investors. The meaningful interpretation and analysis of balance sheets, income
statements and cash flow statements to discern a company's investment qualities is the basis for
smart investment choices. However, the diversity of financial reporting requires that we first
become familiar with certain general financial statement characteristics before focusing on
individual corporate financials. In this article, we'll show you what the financial statements have
to offer and how to use them to your advantage.

1. Financial Statements Are Scorecards

There are millions of individual investors worldwide, and while a large percentage of these
investors have chosen mutual funds as the vehicle of choice for their investing activities, many
others are also investing directly in stocks. Prudent investing practices dictate that we seek out
quality companies with strong balance sheets, solid earnings and positive cash flows.

Whether you're a do-it-yourself or rely on guidance from an investment professional, learning

certain fundamental financial statement analysis skills can be very useful. Almost 30 years ago,
businessman Robert Follet wrote a book entitled "How To Keep Score In Business" (1987). His
principal point was that in business you keep score with dollars, and the scorecard is a financial
statement. He recognized that "a lot of people don't understand keeping score in business. They
get mixed up about profits, assets, cash flow and return on investment."

The same thing could be said today about a large portion of the investing public, especially when
it comes to identifying investment values in financial statements. But don't let this intimidate
you; it can be done. As Michael C. Thomsett says in "Mastering Fundamental Analysis" (1998):

"That there is no secret is the biggest secret of Wall Street and of any specialized industry. Very
little in the financial world is so complex that you cannot grasp it. The fundamentals, as their
name implies, are basic and relatively uncomplicated. The only factor complicating financial
information is jargon, overly complex statistical analysis and complex formulas that don't convey
information any better than straight talk."

2. What Financial Statements to Use

For investment analysis purposes, the financial statements that are used are the balance sheet,
the income statement, the cash flow statement, the shareholders' equity and retained earnings. A
word of caution: there are those in the general investing public who tend to focus on just the
income statement and the balance sheet, thereby relegating cash flow considerations to
somewhat of a secondary status. That's a mistake; for now, simply make a permanent mental note
that the cash flow statement contains critically important analytical data.

3. Knowing What's Behind the Numbers

The numbers in a company's financials reflect real world events. These numbers and the
financial ratios/indicators that are derived from them for investment analysis are easier to
understand if you can visualize the underlying realities of this
essentially quantitative information. For example, before you start crunching numbers, have an
understanding of what the company does, its products and/or services, and the industry in which
it operates.

4. The Diversity of Financial Reporting

Don't expect financial statements to fit into a single mold. Many articles and books on financial
statement analysis take a one-size-fits-all approach. The less-experienced investor is going to get
lost when he or she encounters a presentation of accounts that falls outside the mainstream or so-
called "typical" company. Simply remember that the diverse nature of business activities results
in a diversity of financial statement presentations. This is particularly true of the balance sheet;
the income and cash flow statements are less susceptible to this phenomenon.

5. The Challenge of Understanding Financial Jargon

The lack of any appreciable standardization of financial reporting terminology complicates the
understanding of many financial statement account entries. This circumstance can be confusing
for the beginning investor. There's little hope that things will change on this issue in the
foreseeable future, but a good financial dictionary can help considerably.

6. Accounting Is an Art, Not a Science

The presentation of a company's financial position, as portrayed in its financial statements, is

influenced by management estimates and judgments. In the best of circumstances, management
is scrupulously honest and candid, while the outside auditors are demanding, strict and
uncompromising. Whatever the case, the imprecision that can be inherently found in the
accounting process means that the prudent investor should take an inquiring and skeptical
approach toward financial statement analysis.

7. Two Key Accounting Conventions

Generally accepted accounting principles (GAAP) or International Financial Reporting
Standards (IFRS) are used to prepare financial statements. Both methods are legal in the United
States, although GAAP is most commonly used. The main difference between the two is that
GAAP is more "rule based," while IFRS is "principle based." Both have different ways of
reporting asset values, depreciation, inventory and more.

8. Non-Financial Statement Information

Information on the state of the economy, industry and competitive considerations, market forces,
technological change, and the quality of management and the workforce are not directly reflected
in a company's financial statements. Investors need to recognize that financial statement insights
are but one piece, albeit an important one, of the larger investment information puzzle.

9. Financial Ratios and Indicators

The absolute numbers in financial statements are of little value for investment analysis, which
must transform these numbers into meaningful relationships to judge a company's financial
performance and condition. The resulting ratios and indicators must be viewed over extended
periods to reflect trends. Here again, beware of the one-size-fits-all syndrome. Evaluative
financial metrics can differ significantly by industry, company size and stage of development.

10. Notes to the Financial Statements

It is difficult for financial statement numbers to provide the disclosure required by regulatory
authorities. Professional analysts universally agree that a thorough understanding of the notes to
financial statements is essential in order to properly evaluate a company's financial condition and
performance. As noted by auditors on financial statements "the accompanying notes are an
integral part of these financial statements." Take these noted comments seriously.

11. The Annual Report

Prudent investors should only consider investing in companies with audited financial statements,
which are a requirement for all publicly-traded companies. Perhaps even before digging into a
company's financials, an investor should look at the company's annual report and the 10-K.
Much of the annual report is based on the 10-K, but contains less information and is presented in
a marketable document intended for an audience of shareholders. The 10-K is reported directly to
the SEC and tends to contains more details.

Included in the annual report is the auditor's report, which gives an auditor's opinion on how the
accounting principles have been applied. A "clean opinion" provides you with a green light to
proceed. Qualifying remarks may be benign or serious; in the case of the latter, you may not
want to proceed.

12. Consolidated Financial Statements

Generally, the word "consolidated" appears in the title of a financial statement, as in

a consolidated balance sheet. Consolidation of a parent company and its majority-owned (more
that 50% ownership or "effective control") subsidiaries means that the combined activities of
separate legal entities are expressed as one economic unit. The presumption is that a
consolidation as one entity is more meaningful than separate statements for different entities.

The Difference in Income Statements of a Service Company

Vs. a Merchandising Company

In modern economy, sales revenue is the fuel that sustains services, innovation and competition
-- whether the income stems from a service company or a merchandising business. If you pore
over an organization's income statement, you see things like revenues, cost of goods sold and
administrative expenses -- all of which lead to net income or loss at the end of the reporting
period.

Income Statement

When much of the economy languishes, you can delve into a corporation's income statement to
figure out whether it's bowing to the overall negative environment or whether top leadership can
maintain the business in profitable-company status. If the corporation is flourishing, you'll see
that at the bottom of the statement of profit and loss -- an identical term for an income report,
P&L or statement of income. Also known as the bottom line, net income equals total revenues
minus total expenses. A net loss arises if expenses exceed revenues.
Service Company

A service company is an organization that doesn't sell goods to make money, but rather relies on
the analytical dexterity and innovation of its personnel to provide services that clients want and
relish. Think of companies involved in investment banking, insurance, consulting, accounting
and advisory and financial planning. In a service company's income statement, you typically see
items, such as revenues, cost of services, sales and marketing and reorganization costs. You also
note things like interest expense, fee income and provision for income taxes -- or income taxes,
for short.

Merchandising Business

Merchandising consists of methods and tactics a business uses to sell products or provide
services to retail customers. As a result, a merchandising business is any entity engaging in the
chain of events that starts from displaying products on shelves and ends with selling them to
clients. A department store, for example, fits the description of a merchandising business. In the
company's income statement, you see things like sales revenue, product rebates, cost of goods
sold, storage, shipping and hazardous material insurance -- in sum, any cost relating to the
conveyance, maintenance and handling of merchandise.

Bottom Line

An income statement -- whether it be for a merchandising business or a service company -- helps

regulators and investors understand what goes on behind closed corporate doors. Report readers
pay attention to profitability data, but they also heed whether senior executives lived up to their
creed of financial transparency and regulatory compliance during the period under review.
Accounting rules generally require that a business post expense and revenue information while
revealing relevant facts about how it makes money, products it relies on to sustain itself
competitively and top customers that generate the bulk of corporate revenue.

Difference in Merchandise & Service Income Statements

The primary difference between a merchandising and a service-based business is the
presence of inventory. Merchandising businesses sell goods to customer, whereas service-
based businesses do not. The companies' financial statements, including the income
statements, must reflect this difference.

Cost of Goods Sold

When you review a service income statement while simultaneously viewing a merchandising
income statement, the first difference you'll notice is that the latter carries an account called "cost
of goods sold," while the former does not. Service-based businesses don't carry inventory and
therefore don't use this account. For a merchandising company, cost of goods sold is an expense
account that refers to the cost of purchasing the inventory and shipping it to the appropriate
locations for selling to customers.

Calculating Cost of Goods Sold

To calculate cost of goods sold in a merchandising company, calculate the beginning inventory
and purchases throughout the year, then subtract the ending inventory. The beginning inventory
is the amount that's present on the previous year's income statement, while ending inventory is
the amount available for sale as of the date of the current year's income statement. Purchases
include any shipping costs that you incur from the manufacturer or distributor. Cost of goods
sold is usually one of the greatest expenses that a merchandising company incurs and one of the
most important accounts on the income statement.

Calculating Net Income

The main purpose of the income statement is to list a company's revenues and expenses, and to
present the net income of a business for the year. In both types of income statements, net income
is simply the revenues, or sales, of the company minus all operating expenses. A service-based
business will usually experience a decline in net income largely due to a decline in revenue,
rather than an increase in expenses. In a merchandising company, a decrease in net income is just
as likely to occur because of an increase in expenses as a decrease in revenues. The income
statements of both types of companies help to pinpoint which area the company needs to focus
on.

Manufacturing Income Statement

The income statement from a manufacturing company closely resembles that of the
merchandising company, however there are a few added expenses. Cost of goods sold for a
manufacturing company is much more complex as the company must take into account the cost
of raw materials, labor and overhead that creates the finished goods. Some companies choose to
present all of this information on their income statements, while others only present it as a final
total for cost of goods sold.